Three Investment Ideas to Avoid…or Sell Short

“Well, hell, I didn’t work at Enron either.” – Jim Chanos (who smoked out the fraud at Enron) responding to criticism that he has bearish views on China without ever having visited the country.

Jim Chanos is a man who sells his stocks first and then buys them later – hopefully, in his case, at much lower prices. He profits when stocks go down. Chanos is perhaps most famous as the man who sniffed out the fraud that was Enron. In Wall Street parlance, he is a short seller.

At the recent Grant’s Investment Conference in New York, this great short-seller gave the audience a half-dozen short sale ideas. He called them “value traps” because they look cheap on the surface but have serious problems underneath. You don’t want to own any of these investment ideas.

I’d like to highlight three of them.

The first is the flip side of the shale gas boom. You know the outlines of this story already. New technology has cracked open once-unreachable natural gas. Gushing new gas wells have dropped North American natural gas prices to around $2. That’s a drop of over 50% from last year and 75% from five years ago.

Suddenly, cheap natural gas means coal-fired power generation is in trouble, as more switch to natural gas. US coal prices are down 20-32% from last year, depending on where you are and what type of coal. Coal train carloads are down 18% from a year ago.

Chanos’ favorite short here is CONSOL Energy (NYSE:CNX). Thermal coal made up 45% of 2011 gross profits. Higher-grade met coal made up 38% of profits. On these coal assets, CNX competes with low-cost exporters from Australia, Indonesia, South Africa and Colombia.

CNX also has quite a bit of leverage. In the last three years, it’s barely produced any free cash flow. Might further drops in coal prices force a crisis at CNX? It seems the Street’s opinion of what CNX will earn is changing rapidly. Just 90 days ago, the consensus was $3.19 in earnings per share this year and $3.62 next. Now that consensus is $2.08 and $2.63, respectively.

Avoid coal stocks in general and CNX in particular.

The next idea was national oil companies, which Chanos pointed out, “are being run for the benefit of the states.” The general model for a national oil company is for the government to retain a big stake in the company, push for costly investments and keep prices at the pump low.

The short idea here is Petrobras (PBR), the Brazilian oil company that found the big pre-salt deposits in the Atlantic to much ballyhoo. PBR seems a good-looking value story on the surface. It has a forward price-earnings ratio of only 7.5 times. The stock price is down 40% in the last two years. And it has, to its credit, the biggest oil find in the Americas in a generation.

Yet these virtues mask serious problems…

Chanos points to the enormous (and risky) capital spending program out to 2015 – a $225 billion commitment that will require $14 billion in divestitures and $86 billion in additional debt.

Meanwhile, the Brazilian government, like a kitten slapping a ball of yarn, is smacking Petrobras around for its own political reasons. So there are price caps at the gas pump, thereby capping PBR profits. PBR also must source 65% of its services domestically, handcuffing it in finding the best deals. And finally, PBR is building a huge fleet of ships at a time when there are already too many ships.

As Chanos showed, the end result of all this social engineering is some very poor results. For starters: Production growth of only 1.4% per year from 2006-11 and $13 billion in negative cash flow after dividends in 2011.

I will add here that I think the whole country of Brazil is in a bit of trouble. Longtime readers will not be surprised, as I’ve been warning about Brazil for more than a year now. Let me recount just some of the ways it alarms me:

Brazil’s tax burden is among the highest in the emerging world. It’s comparable to France or Norway and not competitive with its emerging market peers

Government spending is nearly 40% of the economy. Brazil already has a welfare state it can’t afford.

In the ease of doing business surveys, Brazil ranks 126th out of 183 countries. That’s an embarrassment. It’s easier to do business in Rwanda, Guatemala and Pakistan than it is to do business in Brazil.

Infrastructure is poor and not getting much better. Poor roads and ports lead to long queues, spoilage and wasted time. Investment in infrastructure is only 2% of the economy, compared with the 5% emerging market average.

Crime is a big problem. No wonder Brazil is the world’s second- largest market for armored cars. Eike Batista, Brazil’s richest man, doesn’t go anywhere without a small army. This is normal among the elite.

Why people continue to think Brazil is a good place to invest can only be because of Brazil’s inherent sex appeal. It seems to have everything. My recommendation is go ahead, go to Brazil. Have a good time. Go to the beaches. Enjoy the caipirinhas. Then invest your money someplace else.

The third idea from Chanos that I’ll highlight is iron ore. As China has boomed, so has its demand for iron ore. China alone makes up 66% of global iron ore consumption. China’s boom has taken a ho-hum commodity and made it exciting.

How sustainable is today’s price? Already, Chinese demand seems to be flattening out. And as Chanos pointed out, iron ore is not particularly rare. You just have to dig it up and get it to the coasts, which is what people have been doing. There has been tremendous investment in rail and mines in the last several years. All of the major iron ore producers are ramping up production at a time when Chinese demand is flagging.

Chanos highlighted Fortescue Metals as the one he thinks will crater. Once again, it seems to have the outlines of a “value story” – it has high profit margins, low costs and plans to nearly triple production by 2013.

The problems: 98% of sales go to China, it has a high level of debt and it suffers from rising costs.

So those are a few ideas from Chanos. Don’t own coal producers, national oil companies or iron ore producers. And especially avoid CNX Energy, Petrobras and Fortescue Metals. I strongly agree with Chanos’ take on all three of these ideas, which is why I decided to bring them to your attention.

There is also a good lesson here: You can’t just look at surface appearances and expect to do well in stocks. There is much more to handicapping the success of an investment than just looking at what everyone sees and knows about. It is essential to understand the story behind the numbers.

Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.

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